Persistent noise, investors’ expectations, and market meltdowns
Giovanni Cespa, Xavier Vives22 April 2014
Since capital flows to and from hedge funds are strongly related to past performance, an exogenous liquidity shock can trigger a vicious cycle of outflows and declining performance. Therefore, ‘noise’ trades – usually thought of as erratic – may in fact be persistent. Based on recent research, this column argues that there can be multiple equilibria with different levels of liquidity and informational efficiency, and that the high-information equilibrium can under certain conditions be unstable. The model provides a lens through which to interpret the ‘Quant Meltdown’ of August 2007 and the recent financial crisis.
The recent financial crisis has revived interest in the question of what triggers crashes and meltdowns in financial markets. An important reason for abrupt and large price dislocations is the lack or ‘slow motion’ of arbitrage capital (Duffie 2010) that weakens the risk-bearing capacity of liquidity providers.
We suggest that there is an alternative explanation based on expectations dynamics in the presence of persistent market noise.
The transmission of Federal Reserve tapering news to emerging financial markets
Joshua Aizenman, Mahir Binici, Michael M Hutchison04 April 2014
In 2013, policymakers began discussing when and how to ‘taper’ the Federal Reserve’s quantitative easing policy. This column presents evidence on the effect of Fed officials’ public statements on emerging-market financial conditions. Statements by Chairman Bernanke had a large effect on asset prices, whereas the market largely ignored statements by Fed Presidents. Emerging markets with stronger fundamentals experienced larger stock-market declines, larger increases in credit default swap spreads, and larger currency depreciations than countries with weaker fundamentals.
The quantitative easing (QE) policies of the US Federal Reserve in the years following the crisis of 2008–2009 included monthly securities purchases of long-term Treasury bonds and mortgage-backed securities totalling $85 billion in 2013. The cumulative outcome of these policies has been an unprecedented increase of the monetary base, mitigating the deflationary pressure of the crisis.
Capital inflows and booms in asset prices: Going beyond the current account
Eduardo Olaberría07 December 2013
Policymakers have long been concerned that large capital inflows are associated with asset-price booms. This column presents recent research showing that the composition of capital inflows also matters. The association between capital inflows and asset-price booms is about twice as strong for debt-related than for equity-related investment. Policymakers should therefore pay attention to the composition of capital inflows, since debt-related inflows may still undermine financial stability even if they do not result in an overall current-account deficit.
For decades, policymakers’ perception has been that large capital inflows can fuel booms in asset prices. If this were true, bonanzas in capital inflows would imply an important risk to financial stability, since booms in asset prices are leading indicators of financial crises. However, as noted by Reinhart and Reinhart (2008: 50), despite being widespread among policymakers, until recently this perception was based mainly on anecdotal evidence.
Indraneel Chakraborty, Itay Goldstein, Andrew MacKinlay25 November 2013
Higher asset prices increase the value of firms’ collateral, strengthen banks’ balance sheets, and increase households’ wealth. These considerations perhaps motivated the Federal Reserve’s intervention to support the housing market. However, higher housing prices may also lead banks to reallocate their portfolios from commercial and industrial loans to real-estate loans. This column presents the first evidence on this crowding-out effect. When housing prices increase, banks on average reduce commercial lending and increase interest rates, leading related firms to cut back on investment.
Policymakers around the world often worry about decreases in real-estate prices and other asset prices, and take measures to prevent them. For example, in the aftermath of the financial crisis, the Federal Reserve has engaged in large-scale asset purchases – especially of mortgage-backed assets – to support the housing market and, in turn, the overall economy.
Speculative investors and transaction tax in the housing market
Yuming Fu, Wenlan Qian, Bernard Yeung07 November 2013
Financial transaction taxes are designed to raise revenue and stabilise financial markets, but their effect on market volatility is controversial. This column presents evidence from the sudden reintroduction of stamp duty on new housing projects in Singapore. Overall trading volume declined while volatility increased. These effects were strongest for previously underpriced projects, consistent with the hypothesis that informed speculators were more strongly discouraged by the tax than noise traders. This suggests that financial transaction taxes may reduce the informativeness of asset prices.
The Global Financial Crisis revived the idea of using transaction taxes to discourage short-term speculative trades. Such trading is often blamed for causing excess volatility in financial markets. Tobin (1978) proposed the tax more than 40 years ago, to “throw some sand in the wheels of speculation”, specifically for currency trading. The idea has been extended to all forms of financial transactions.
Fama, Hansen, and Shiller: An excellent choice of Nobel laureates
Tarun Ramadorai24 October 2013
The 2013 Nobel laureates’ work has greatly improved our understanding of asset markets. Their blend of rigorous statistical analysis, economic theory, and respect for ‘market wisdom’ has provided a huge impetus to the field of empirical asset pricing – one of the most important and active areas of economics research. The insights gained in this field have important real-world implications, helping individuals to make better investment decisions and policymakers to design more appropriate financial regulations.
The recent announcement of the 2013 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has delighted researchers working in empirical asset pricing. The combination of deep economic insight and clever methodological contributions that Eugene Fama, Lars Hansen, and Robert Shiller have brought to this field has revolutionised our understanding of the determinants of asset prices.
Existing literature continues to be unable to offer a convincing explanation for the volatility of the stochastic discount factor in real world data. This paper provides such an explanation, demonstrating that financial markets, by their very nature, cannot be Pareto efficient except by chance. Although individuals in our model are rational; markets are not.
Origins and macroeconomic implications of asset bubbles
Alberto Martin, Jaume Ventura16 February 2011
Modern economies often experience large movements in asset prices that have significant macroeconomic effects. Yet many of these movements in asset prices seem unrelated to economic fundamentals and are often termed “bubbles”. This column explains how recent advances in the theory of rational bubbles can help us to understand these movements in asset prices and their macroeconomic implications.
What is a bubble? Today’s economies often experience large movements in asset prices that have significant macroeconomic effects. Given that many of these movements in asset prices seem unrelated to economic conditions or fundamentals, they have come to be called bubbles, whether swelling or bursting. Typically, these bubbles are unpredictable and generate substantial macroeconomic effects. Consumption, the capital stock, and output all tend to surge when a bubble arises and then collapse or stagnate when the bubble bursts.
Robert Barro, Emi Nakamura, Jón Steinsson, Jose F. Ursua08 July 2010
Previous research suggests that the potential for rare, but large, economic disasters helps explain the equity-premium and related asset-pricing puzzles. This column presents evidence from a new empirical model of consumption disasters and discusses a range of assumptions required for the model to predict the observed long-run average equity premium.
Previous research, including Rietz (1988) and Gabaix (2009), suggests that the potential for rare, but large, economic disasters helps to explain the equity-premium and related asset-pricing puzzles. Motivated by these findings, our research described in Barro et al. (2010) uses data on per capita personal consumer expenditure for 24 countries over more than a century to estimate an empirical model of consumption disasters.